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Production Cost & RevenueProduction, Costs and RevenueTo
give basic idea about production function.To give basic idea about
various costs and revenue concepts.To show the behavior and shapes
of short and long run costs and revenue concepts and the reasons
behind that.To give basic idea about economies of scales and scope
concepts.To give basic idea about profits maximization.Application
of these concepts to practice.
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Production, Costs and Revenue
Production, costs and revenues are related with the supply
theory. Can we analyze various business organizations through one
theory or do we need many theories. One general framework with
adjustment to suit with various market structures. Before deciding
the output level, firm has to know two important issues: How much
will it cost to produce and how much revenue will it generate Firm
choosesLevel of output and fixed the priceCost of
productionRevenuePriceOutput
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Modeling
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Production The term production refers to more than the physical
transformation of resources. Production involves all the activities
associated with providing goods and services. Thus the hiring of
workers (from unskilled labor to top management), personnel
training, and the organizational structure used to maximize
productivity are all part of the production process.Input: any good
or service used to produce output.A technique: a particular method
of combining inputs to make outputs.Technology: is the list of all
known techniquesTechnical progress: production of a given output
with less inputs than before or shift in production possibility
curve.
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The Production Function- A production function is a descriptive
statement that relates inputs to outputs.- A technical relationship
between physical inputs and outputs.- It specifies the maximum
possible output that can be produced for a given amount of inputs.-
The minimum quantity of inputs necessary to produce a given level
of output. - Production functions are determined by the technology
availability to the firm.
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FirmBlack BoxThe Production FunctionInputs - FOPs (Factors of
production)(labour, land, materials, capital, knowledge, etc)
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The Functional Form Q = f (costs, ...)
This can be separated into :Q = f (K, L, La, M, ...)Q = output,
K = capital, L = labour, La = land, M = materials
Or in its most usual form :Q = f (K, L)
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Technical efficiency and economic efficiency in production
Technical efficiency is a method of production which involves
the minimum amount of a combination of different factors .
Economic efficiency is the use of resources to produce any given
output level at minimum cost .See page no. in your second text
book
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Time Duration in Economics
The Short Run (Time period when at least one factor is in fixed
supply. Output can be changed by using variable factor with the
fixed factor. The length of the short run change firms to firms and
industry to industry.)
Q = f (K - fixed factor, L - variable factor)
The Long Run (No fixed factors or all the factors are variable
except technology.)
The Very Long Run (The time period over which technology might
change.)
Economists analyze production, costs and revenue with respect to
these short and long run periods.
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Fixed and Variable Factorsin the short run (SR), at least one of
the factors is fixed in supply (the operating period)can split SR
costs into fixed and variablefixed costs are costs which do not
vary in the short-run with the level of output(e.g. rent, interest
payments, capital depreciation..)variable costs are costs which do
vary in the short run with the level of output(e.g. raw materials,
heating and lighting, waged labour...)
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In studying production functions, there are two types of
relations between inputs and outputs that are of interest for
managerial decision making. 1. Returns to scale Relation between
output and the variation in all inputs taken together.This plays an
important role in managerial decisions. They affect the optimal
scale, or size of a firm and its production facilities. They also
affect the nature of competition in an industry and thus are
important in determining the profitability of investment in a
particular economic sector.
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2. Returns to a factorThe relation between output and variation
in only one of the inputs employed.The terms factor productivity
and returns to a factor are used to denote this relation between
the quantity of an individual input (or factor of production)
employed and the output produced.Factor productivity provides the
basis for efficient resource employment in a production system.
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TOTAL, AVERAGE, AND MARGINAL PRODUCTTotal Product (TP): The
total output that results from employing a specific quantity of
resources in a production system. Generally this TP will rise as
more units of labor are employed with fixed volume of capital. But
the trend of this curve has different rates of increases: first it
increases at an increasing rate, then at a decreasing rate and
finally it will decline. The explanation for this behavior can be
explained through the concept of marginal product. Marginal Product
(MP): The change in output associated with a unit change in one
input factor, holding other inputs constant.MP = d(TP)/dQ or
ATP/AQThis curve first goes up due to workers specialization and
spare capacity in fixed factor and then goes down due to full
utilization of the fixed factor.
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Average Product (AP)Total product divided by the units of inputs
employed.AP = TP/LThis curve first goes up then goes
downRelationship between AP and MP: AP goes up then MP above it and
AP goes down then MP below it. This relationship can be explained
through principle of diminishing returns.Principle of Diminishing
Returns: More units of a variable factor (L) are combined with a
given number of fixed factors (K) there comes a point where the
returns to the variable factor begin to decline.
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Average and Marginal Products
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The Law of diminishing returnsAs the quantity of a variable
input increases, with the quantities of all other factors being
held constant, the resulting increases in output eventually
decrease. Holding all factors constant except one, the law of
diminishing returns says that, beyond some level of the variable
input, further increases in the variable input lead to a steadily
decreasing marginal product of that output.
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Cost AnalysisCost Analysis plays a central role in managerial
economics because virtually every managerial decision requires a
comparison between costs and benefits. There are number of other
cost concepts.Relevant cost and Opportunity costAccounting cost and
economic costExplicit vs implicit costsMarginal cost or Incremental
CostSunk cost (while leaving industry you can not recover this
costs) and fixed costShort and long-run costs
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Short-run Costs
Short-run Total Costs
Total Cost: TC (fixed and variable costs in production)
Total Fixed Cost: TFC (Cost which does not change with output
and it is the overhead or capital costs. The curve is a horizontal
or flatter)
Total Variable Cost: TVC (Cost which change with output: labor
and raw materials). This curve is the inverse shape of TP
curve.First it increases at decreasing rate (additional unit of
labour add more value to production) and then increases at
increasing rate (additional unit of labour add more to cost rather
to production).
TC = TFC + TVC, TFC = TC - TVC, TVC = TC - TFC
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Short-run Average Total Costs
TC/Q = TFC/Q + TVC/QATC = AFC + AVC
AFC (falls as output increases and it is continually down-ward
slopping. It is the fixed costs per unit of output produced).
AVC (first falls and then rise and it is the inverse shape of AP
curve: AP rises then AVC falls AP falls then AVC rises due to
changes in labor productivity.
ATC (first falls and then rise mainly due to AVC curve)
AFC = ATC - AVC, AVC = ATC - AFC
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Marginal Cost is the increase in total cost when output is
increased by 1 unit:
MC = d(TC)/dQ
Its behaviour starts at high then falls then again rises.The
main reasons for this behaviour is production techniques (at low
level of output simple techniques then costs go upOutput increases
sophisticated techniques then economies of scales. Output further
increases diseconomies of scales such as Organizational problems
cost go up).
Generally MC, AVC and ATC show some relationship.If MC < AVC
then AVC fallsIf MC = AVC then AVC is at minimumIf MC > AVC then
AVC risesSame relationship holds between MC and ATC
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MRCost
OutputProfit maximising output Q1
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Bringing FC and VC togetherCost ()Quantity (no. of units)0
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ATC and MCCost ()Quantity (no. of units)0
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The Relationship between Average and Marginal Curves
AC is falling when MC is less than AC, and rising when MC is
greater than AC (AC is declining whenever MC is below AC, and
rising whenever MC above).
AC is at minimum at the output level at which AC and MC cross
(MC cuts the minimum point of AC).
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Short-run Optimality
Full or optimum capacity = firm produces at minimum level of
short-run average cost curve and at this point all the inputs are
employed to their optimum efficiency.
If the firm faces long U shape (Saucer) cost curve, the range of
the minimum points are called load factor or normal capacity
utilization.
If firm producing a point right to this then its average costs
is rising.
If firm is producing left to this point then firm has a reserve
capacity; firm is not fully utilizing its factors of
production.
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Self-study Exercise 1: Identify the main fixed and variable
costs need to operate within the following industries...Newspaper
businessJewellery retailingElectronic components
manufactureElectricity generationSoftware developmentCellular
telecommunicationsHotel management
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in the long run, quantities of all inputs can be varied (the
planning horizon)this means that there are no fixed costs in the
long runand so the LRAC curve is different from the SRAC weve
considered so far. It is more enlarge U (saucer) shaped one. It is
the envelope of the short-run cost curves.LR Average Costs
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The Long Run Average Cost Curveunits of output0cost ()LRMCThe
relationships between LRAC and LRMC same like in short-run.
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Economies and diseconomies of scaleThere are economies of scale
(increasing returns to scale) when long-run average cost decreases
as output rises or volume of output rises more quickly than the
volume of inputs. There are constant returns to scale when long-run
average cost are constant as output rises or volume of output
increases in the same proportion to the volume of inputs .There are
diseconomies of scale (decreasing returns to scale) When long-run
average cost increase as output rises or volume of output rise less
quickly than the volume of inputs. These are explained by the
presence of both internal and external economies and diseconomies
of scale in production.
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Returns to ScaleCost ()Quantity (no. of units)0Decreasing
returns to scale
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Increasing returns to scaleRead the given handout part
Internal economies of scale economies internal to the firm
resulting from a more efficient utilization of resources. This can
be technical or non-technical: labour, investment indivisibilities,
large scale procurement, R &D,capital, diversification,
promotion, transport and distribution, by-products, specialization,
flexible manufacturing large scale necessary to take advantage,
reserve capacity, end of learning period.
External economies of scale economies brought about by the
growth or conentration of the industry: existence of good labour
force, existence of network of suppliers, existence of social
economic and environmental infrastructure.
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Decreasing returns to scale
(Internal diseconomies of scale - management, labour, other
inputs, External diseconomies of scale geography of concentration,
range of business, time of the business).
Solution to the decreasing returns to scale1) Relocation of
operation2) Contracting-out3) Reorganization of management
structures4) Lay-off the workers5) Productivity increase by new
technology and HR programmes.
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Minimum Efficient Scale (MES)
The point at which the long run average cost curve first becomes
horizontal (flatter) and it is the technical optimum scale of
production. It gives a firm a strong competitive advantage in the
market place over higher cost producers.Beyond this MES, firms do
not have additional economies of scales.
Expanding scale firms can further enjoy MES status. Then
managerial problems and other diseconomies are going to emerge.
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Economies of Scope
This exist where several different outputs draw on a common
resources and it is a diversification in a same or different
production and marketing lines. This diversification leads to cost
savings. Generally economies of scale and scope reinforce each
other to minimize cost. The Degree of Economies of Scope (DES)
DES = {[TC(An) + TC(Bn)] TC (An + Bn)}/[TC (An+Bn)]TC(An) =
Total cost of producing An units of product A separatelyTC(Bn) =
Total cost of producing Bn units of product B separatelyTC (An+Bn)
= Total cost of producing A and B jointly
DES < 0 Negative ES. It is better to produce separatelyDES
>0 Positive ES. More economical to produce jointly.Generally
economies of scale and economies of scope are reinforcing each
other to reduce costs.
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Sources of Economies of Scale and ScopeEconomies of Scalesource
: adapted from Koutsoyiannis (1979)
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X-inefficiency
The situation of wastage of firms resources and its costs higher
than necessary level. This can happen due to managerial or
technological or any other factor. This firm can not exist market
in long-run. Most of the public sector institutions have this
problem. But generally in the long-run in competitive markets,
firms can not survive if they have X-inefficiency problem: full
efficient firms only survive. We can measure it as actual cost
point - MES = (q1a-q1b) =ababq1LRACC0q
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The Learning Effect (Accumulative productive experience)Firm
accumulate its business experience over the years which improve its
production and organizational methods which ultimately reduces the
cost of production. -learning by doing approach-At managerial level
the learning effects occurs Perfection and precision reached due to
constant practice of managerial decision making. Finding more
efficient production and business procedure. Knowing better ways to
use tools and equipments. Familiarization with the production
activities which helps to give good instructions to subordinates.
Right placement of right people. Better co-ordination and control.
Good integration of works. Better TQM Better project management and
scheduling Cumulative outputCost per unitLRAC
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Learning Effect Rate (LER)
LER = [ 1- (ACt1/ACt0)] *100
ACt1 = Average cost in initial period (t0) incrementACt0 =
Average cost in next period (t1) incrementACt1/ACt0 = Experience
factor
This measures percentage decrease in additional cost with
respect to a 100 per cent increase in output at each time.
For working examples see Mithani.D.M (2000),Managerial
Economics, Theory and Applications,Himalaya Publishing House, Page
280-1
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Self-study Exercise 2: What are the potential sources of
economies of scale and scope in the following industries/Or in your
firm/organization?
1) Consumer finance2) Pharmaceuticals3) Printing4) Road
construction5) Recorded music industry6) Shoe manufacture &
retail7) Training and education provision
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Profits Maximization
Total Revenue - Total Costs = Profits
TR - TC = Profitsd(TR)/dQ - d(TC)/dQ = Marginal profitsMR = MC,
Profits maximizing condition or ruleMarginal revenue = Marginal
cost
Profits maximising output decision:MR > MC Q should goes upMR
= MC Q profit maximising outputMR < MC Q should goes down
Profits maximising output and revenue maximising output are two
different concepts (see next table).
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Marginal Cost is the increase in total cost when output is
increased by 1 unit:
MC = d(TC)/dQ
Its behaviour starts at high then falls then again
rises.MCQ0MC
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Marginal revenue is the increase in total revenue when output is
increased by 1 unit. Its behaviour depends on the firms demand
curve . Generally it is a downward for most market structures
except perfect competition (horizontal).MR/D/PMRAR =DPerfect
CompetitionOther MarketsQPQP00
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MRProfits maximising output Q1MR > MCMC < MR
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See figure a (TR, TC and profits curves)
1) Break even points Q1 and Q4 (TR = TC).2) Loss making area
below Q1 and above Q4 (TC>TR).3) Profits making area between Q1
- Q4 (TR>TC).4) Maximum profits in Q2 (highest difference
between TC and TR).
See figure b (MC, AC, AR and MR curves)These two figures are
interrelated:1) Break even points Q1 and Q4 (AC=AR).2) In loss
making area below Q1 and above Q4 (AC > AR).3) Profits making
area between Q1 and Q4 (AR > AC).4) Maximum profits in Q2 (MR
=MC, Moving to right from Q1 MR>MC. Moving to left from Q4
MR>MC, Moving right to Q2 MR
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Figure aFigure b
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Normal Profits
At a breakeven point firm makes zero profits. But economists
name it as a normal profits based on the opportunity cost
concept.
Abnormal Profits (Super normal profits)
Surplus above the normal profits. Between Q1 and Q4
Shut-Down Price
Below the normal profits firm does not get full cost recovery.
Therefore, they will decide to shut-down the business.
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SRMCSRACSRAVCD1 =MR1D2 =MR2D3 = MR3D4 = MR4D5 =
MR5P1P2P3P4P50Q1Q2Q3Q4Q5OutputPrice and CostThe Shut-down Position
in Short-runAbnormal profitsNormal profitsShut-down price
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Exercise
Usage of profits maximizing model to loss making firm - Baldwins
fashion Ltd
This firm make profits till very recent but now in loss and
considering closing down. Your advice to regain the profits and to
remain in the industry.
Solutions:
1) Decreasing variable costs2) Decreasing fixed costs3)
Increasing the level of demand4) Combinations of all these
**4*77*6*